Playboy Plays the Bond Market

When the Vice-President of a big Wall Street investment firm recently described the bond market as "a great American tragedy," he was not exaggerating. Day after dreary day this past May and early June, virtually every bond in the country enjoyed a market value less than its purchaser had paid for it. The money tied up in bonds was more than sufficient to retire the national debt--and hardly a penny of it represented profit. The collapse was so total that it could only compare with the great stock-market crash 40 years earlier. Between August 1968 and May 1970, corporate bonds--traditional shelter for widows and orphans--fell an average of 30 percent; municipal bonds--those issued by cities and towns--fell 34 percent. In both cases, this was the worst decline of the 20th Century.

But one man's tragedy can be another's good fortune. The investors burned in the bond crash were mostly those who could well afford it: immensely wealthy individuals and even wealthier institutions. Only recently have smaller investors been drawn to bonds, though their impact has been profound. The best current estimates indicate that individuals are increasing their bond holdings at a rate close to 30 billion dollars a year. That's $150 for every man, widow and orphan in the country. More remarkable yet, chances seem good that these newcomers will profit--perhaps considerably. Crashes in any market are traditionally followed by bargains. Historically high interest rates and historically low bond prices may be offering investors the sort of opportunity that comes but once or twice in a lifetime. At the least, current or would-be investors ought to find out what bonds are all about.

A bond is an interest-paying I. O. U. The borrower is usually a corporation or a Government agency and the lender can be anyone who has money to lend at interest. The totals involved are astronomical, but for symmetry's sake, they are divided into $1000 units. In return for each $1000 it receives, the borrower provides an engraved certificate, therein promising to pay the bondholder a fixed rate of interest (usually twice a year) and to repay the $1000 at the expiration of the contract (the maturity date), which might be 20 or even 40 years off. A few bond certificates represent amounts other than $1000, but these are a tiny minority and, for purposes of discussion, it's convenient and not terribly misleading to assume that all bonds involve $1000 amounts.

To sell its I. O. U.s successfully, the borrower must be willing to pay an interest rate sufficiently high to attract money from would-be lenders. In this free-market process, in which borrowers and lenders haggle over prices and finally reach agreement, the ever-changing cost of money--the general interest rate--is established. Once a bond is issued, its rate of return is fixed for life. A $1000 bond yielding eight percent, for instance, will pay its owner an income of $80 a year, no more and no less, until it matures. But the general interest rate is not fixed. It fluctuates daily, even hourly. And since a bond represents a fixed stream of income, its resale value after it is issued goes up or down according to fluctuations in the general interest rate.

An example should make this clear. As this is written, an investor can purchase, for precisely $1000, a 9-1/4-percent bond recently issued by the Seaboard Finance Company, one of the largest personal-loan firms. This particular bond matures in 1990, so today's buyer is assured of an income of $92.50 a year (9-1/4 percent of $1000) for 20 years, after which (if he still owns the bond) he'll get his $1000 back.

If he wanted his $1000 prior to 1990, he'd have to sell his bond in the open market, in much the same way that he would sell a stock. As with stocks, bonds on the open market are worth only what others will pay for them. In the bond market, buyers are usually willing to pay prices that closely coincide with the prevailing interest rate. If that rate were to remain at 9-1/4 percent, then a bond with an income of $92.50 a year would continue to have a market value of $1000 and the purchaser of the Seaboard 9-1/4-percenter would break even when he sold. But if the prevailing interest rate were to rise, say, to 12 percent, an income of $92.50 a year would no longer be worth $1000. At 12 percent, $92.50 a year could be nailed down for around $770, and that's just about what the Seaboard bond would sell for. And if the prevailing interest rate should decline, say, from nine percent to six percent, an investor would have to pay over $1500 for an income of $92.50 a year. So (continued on page 191)Bond Market(continued from page 113) at this point, the owner of the Seaboard bond could conceivably sell for $1500. By a peculiar form of arithmetical alchemy, a three-percentage-point increase in the general interest rate gives the bondholder (in this instance) a loss of $230, while a decrease of three points gives him a profit of $500.

In capsule form, this is how all bonds work. Because they represent a fixed stream of income, their market value will fall when the general interest rate rises and rise when the interest rate falls. Thus, while all bonds are worth $1000 on the day they're born and on the day they die, their market value wanders considerably in the interim. For the past 25 years, the direction has been downward. Until early this year, the cost of money had been rising steadily, so that the market value of virtually all bonds issued in the past 20 years declined to well below their $1000 face value. Depending on which figures you read, you may have to go all the way back to the closing years of the 18th Century, when the U. S. was fighting an undeclared naval war with France, to find comparably high interest rates--and comparably low bond prices. Top-grade corporate bonds are now yielding over nine percent and a few months ago paid as much as ten; even Government bonds have been offering over eight percent. Older bonds, bearing the lower interest rates, generally sell at the biggest discounts. On the other hand, the older a bond is, the closer it is to its maturity date; and as maturity draws near, a bond's market price will begin to approach maturity value, so that on maturity day--when the bond is redeemed--the two prices are identical. But up to maturity, the basic rule still governs: Bond prices move inversely with the general interest rate. This concept is basic to an understanding of the bond market, yet many small investors have trouble grasping it.

The investor who wants to understand bonds would do well to clear his mind of anything he might know about the stock market, because little of that knowledge will apply and much of it will confuse. Years ago, amateur investors thought that bonds were like stocks, only safer; more recently, the thinking was that bonds were like stocks, only squarer. Both comparisons mislead.

Stocks pay dividends that rise and fall with the fortunes of the firms they represent. Bonds pay interest, at a fixed and invariable rate. Stocks represent fractional ownership, so their market value fluctuates with the prospects of the firm owned. Bonds represent simple debt obligation; short of the issuer's being unable to meet its payments (a rare occurrence), a bond's market value bears little relationship to the prosperity or poverty of its issuer. Stocks, like the corporations they represent, are immortal, unless, of course, the company is caught up in a merger or goes out of business. Bonds have to be cashed in sooner or later. Because of the built-in maturity date, almost every bond in the country is sure to be worth $1000 (or whatever its maturity value might be) on some known day in the future. No stock can make that statement.

The stock market is emphatically a market of individual values. Even in the steepest crash, well-selected stocks will buck the trend, sometimes astonishingly. While listings on the New York Stock Exchange were recently losing a large percentage of their value, one stock, Telex, increased 700 percent. Bonds just don't act that way. With very few exceptions, they move en masse, so that the bond buyer needn't be as choosy as his stock-market counterpart. While the stock speculator has to cope with dozens or even hundreds of variables affecting each security he buys, the bond investor has to be right on only one bet--that the general interest rate will fall. Of course, he might also want to choose a bond backed by a firm that seems likely to avoid bankruptcy; he might want to pick a bond that provides special tax benefits; and, if he plans to hold it until it expires, he might want to select a maturity date that best suits his personal needs. But within these broad strictures, there are hundreds of bonds that will suit him. All are essentially similar. And, assuming he is correct in his assessment of how the general interest rate will move, all will prove similarly rewarding.

Like all Gaul, bonds are divided into three parts: Governments, municipals and corporates. Each of the three has its distinguishing features; but, as they are discussed in turn, bear in mind that bonds, again like all Gaul, share more similarities than differences. There are three ways to make money in the bond market, though most bond investments will involve them in combination.

The traditional route to bond profits is through income. Paying $1000 for a bond that yields ten percent a year will obviously result in an annual profit of $100. In these days of inflation and high taxes, many investors have come to regard income profits as suspect. The big money today is supposedly in growth, and growth is more likely to be found in the stock market. But growth is a relative term. When bonds were paying three percent a year, a computer study showed that stocks, on the average, returned over nine percent. Surely, this was a persuasive case for buying stocks. But now that some bonds themselves are paying over nine percent, the superiority of a common-stock investment--even in the face of inflation--is less clear. A dominant theme in many Victorian novels is that ladies and gentlemen can fare quite well, thank you, by keeping their money working at nine or ten percent a year. In fact, ten percent is all that's needed to make a man wealthy in less than a lifetime; it will turn $10,000 into $1,000,000 in just under five decades. The problem is that today's high interest rates will probably not persist--though it is possible to buy long-term bonds that guarantee present rates for several decades. Sad to say, this sort of interest profit, from all bonds except municipals, is fully taxable; the bond investor adds it to his salary and pays his income tax on the lot.

He can also profit from capital gains, which are the bond-market equivalent of stock growth. If the interest rate drops to six percent, his $1000 bond paying ten percent might bring as much as $1667 if he sells it. Capital-gains profits such as this are a lot more interesting than a fixed income, and they're even taxed at a more favorable rate: half the investor's regular income-tax rate or 25 percent, whichever is less. (The new tax laws add a minor additional tax for high-bracket investors with capital gains over $50,000 a year; but such people don't often get their tax advice from magazine articles, so we needn't worry too much about them.)

The bond investor can also make what for want of a better term, might be called speculative profits--by resorting to such tricks as buying bonds on borrowed money. Unlike stocks, bonds are regarded as gilt-edged collateral. No matter that bond prices have deteriorated for a generation while stock prices during the same period increased perhaps fourfold. Banks, assuming they have the money, are still quite willing to lend up to 90 percent of market value on bonds posted with them as security. (The maximum allowable loan on stocks is currently 35 percent.) For the bond investor interested in capital gains, this favorable loan advantage means he can get a nine-to-one lever working for him.

Of the three types of bonds, investors tend to know least about Government bonds. This is unfortunate, because they boast some interesting attractions. They are easy to buy, sell or borrow against; they pay surprisingly high returns; and, in some cases, they can be purchased directly from the Government without any brokerage fees. While fully subject to Federal income tax, the interest from U.S. Government bonds is exempt from state and local income taxes. The reason most investors know so little about Government bonds probably grows from unfavorable experiences with the one variety almost everyone knows: U.S. savings bonds. Savings bonds are small-denomination instruments with the size and feel of an IBM card, designed to lure money out of the pockets of small investors and into the coffers of the Federal Treasury. They have virtually nothing in common with ordinary Government bonds. Savings bonds are registered in the owner's name and are nonnegotiable; this means they can only be sold back to the Treasury. The Government promotes this as a safety feature, which, in a way, it is. But it's also a colossal liability, because the bonds' nonnegotiability means they cannot be posted as collateral against a loan. Between the bank and the pawnshop, anything of value can be borrowed against--except savings bonds. In addition to this drawback, they offer a lower return than any comparable investment. Not surprisingly, the Government loves to sell them, especially in times of inflation. (Savings bonds are the only Government borrowing device that directly reduces individual purchasing power on a mass scale; thus, they are an ideal means of damping inflationary fires.) Unfortunately, when inflation is severe, the Government can become overenthusiastic. The current savings-bond campaign, built around the phrase "Take stock in America," is a monument to deceptive advertising. If a private borrower tried to use those words to sell bonds, he would very quickly find himself in court. There is nothing stocklike about a savings bond. In selling a low-yield, nonnegotiable debt instrument, the use of the word stock--with its implications of equity and growth--borders on fraud.

To the extent that investors have had firsthand experience with savings bonds, they would probably agree that they are poor investments. Inflation has seen to that. Of course, inflation hurts all fixed incomes and, thus, all bonds. But because buyers of savings bonds have to hold on to them till maturity to receive the advertised interest rate, inflation seems to hit them hardest. As an extreme example: $18.75 invested in a savings bond in 1941 would have yielded $25 a decade later. But in 1951, that $25 had a purchasing power, in terms of 1941 dollars, of only $13.75. The net loss over ten long years was 27 percent--plus taxes owed on the $6.25 interest profit, if profit can be used in this context. The current return on savings bonds, up to five percent, compares almost as unfavorably with today's six-percent rate of inflation.

A concomitant drawback was first brought to this writer's attention by economist Eliot Janeway. Besides being uncannily correct in his bond-market predictions over the past few years, Janeway has been one of the few financial advisors with the courage to speak loudly and publicly against savings bonds. He points out that virtually all savings-bond investors pay taxes on their interest not as it accrues, which is every year, but in one lump sum, when the bonds are finally cashed in. In this case, increasing affluence and the graduated income tax conspire to penalize the investor even further. He is forced to pay taxes on his savings-bond interest at his current tax rate, which, especially for a young investor, is probably the highest he's ever paid in his life and is almost certainly higher than the rate to which he was subject when the bulk of the interest was actually earned. As Janeway puts it: "The Treasury is getting a double windfall on savings bonds--chiseling on the interest rate it pays and cleaning up on the tax rate it collects."

As usual, the people most victimized by savings bonds are those who can least afford it. When a rich man buys them, you can be sure he's not doing it to get richer. He might be currying tax favors, setting himself up for an Administration appointment or heading a local bond-buying drive that will presumably trickle down to the grass roots. But down among the grass roots are millions of Americans who can't afford to be so charitable. These people might plunk down a hard-earned $18.75--a significant fraction of the average weekly pay check--in the mistaken belief that they are buying some kind of stock certificate that will grow as fast as the U. S. Government. Sooner or later, they'll probably get back less value than they gave and still owe taxes on the difference. It's enough to make a buyer suspect not only the bonds but the integrity of the issuer.

All the deceptive transit ads and the free newspaper space could be liberated for more constructive purposes if the Government would simply approach amateur investors the same way it approaches the pros: offering an interest rate competitive with the prevailing cost of money. Because sophisticated investors, by and large, don't buy savings bonds, the Government does have to pay the going rate for most of its borrowings, which are represented by Government bonds. The most difficult barrier here is nomenclature. The three types of Government bonds are distinguishable only by their maturities. Treasury bills (sometimes called certificates) are bonds with the shortest maturities: no more than one year. Treasury notes are bonds issued with maturities varying from one to seven years. Bonds with maturities over seven years are called what they all should be called: Treasury bonds. The perplexing terminology grows from a Congressional edict forbidding any Government bonds (except savings bonds) from paying over 4-1/4 percent interest. No such restrictions apply to notes, so, in good Orwellian tradition, the Treasury has simply declared that any bond maturing in less than seven years isn't a bond at all but a note. Unfortunately, even newspeak can't solve all the Treasury's problems. Maturities over seven years are out of the question, because these would be bonds and the 4-1/4 percent maximum hasn't been competitive since 1967. Notes are a possibility, but the Treasury is extremely reluctant to issue them, presumably because the high interest rate needed to sell them would constitute a tacit admission that costly money (and inflation) will be with us for years.

The confusing result is that the Treasury, probably against its better instincts, has been forced by the battle against inflation to raise its cash in the short-term money market, by selling Treasury bills. This can be an expensive way to raise money. In the good old days, when the Treasury's main customers were big businesses that gobbled up Treasury bills in $1,000,000 lots, at least the paperwork was minimal. But early this year, when a large portion of T-bill offerings was being picked up by small investors at $1000 a shot, the Treasury was suddenly faced with a back-office bookkeeping problem. Incredibly, the Treasury was spending more to process a $1000 T bill than a $1,000,000 one; and T-men estimated that the additional clerical expense attributable to small-investor bill buying rocketed the Government's actual borrowing cost from 8 to 16 percent.

As usual, the cure was worse than the disease. In late February, the Treasury raised its lowest-denomination bill from $1000 to $10,000. At that point, the United States Government found itself in the morally difficult position of offering a risk-free eight-percent return to relatively wealthy investors, with the less affluent being pushed into savings bonds, much less liquid and paying half the T-bill interest rate. This was really an astonishing move, one of those policy decisions that no amount of efficiency explanation can rationalize away. If justice is to be served, the poor should get the bargains, as the rich have a long and glorious tradition of getting by on their own.

The new Treasury policy provoked such a storm of protest from so many quarters that it may have been repealed by the time these words are read. (In early May, the Treasury did offer a series of notes, maturing in 18 months, paying 7.79 percent interest and available in $1000 denominations.) But even if the $10,000 minimum persists, T bills are still an attractive purchase for anyone blessed with ten Gs--or with friends who might want to join him in raising that sum. Treasury bills currently offer just about the highest returns of all Government bonds and they are the only ones that individual investors can purchase without going through a middleman and paying the appropriate fees.

The prospective purchaser has his choice of four maturities: three months, six months, nine months and twelve months. All T bills are bearer obligations: The only names on them are those of Uncle Sam and the issuing Federal Reserve Bank. As with currency, whoever has the bill in his pocket is assumed to be the rightful owner, so the buyer of T bills will obviously want to take care not to lose them. A safe-deposit box is the usual precaution and the expense is tax deductible. Being bearer bonds, T bills make fine collateral; in fact, they are just about as negotiable as cash, with the important distinction that they bear interest. As with all bonds, the interest rate on T bills is fixed for life, with the rate on new ones set at issuance according to the vagaries of the money market. Earlier this year, the yield on three-month T bills crept over eight percent; but more recently, it dropped back below seven.

The standard method of quoting Treasury-bill returns understates their yield. Like savings bonds, T bills are sold at a discount and redeemed at face value. A seven-percent, $10,000, one-year Treasury bill will cost its purchaser $9300 and a year later will be worth $10,000. The $700 interest represents seven percent of $10,000; but, in the investor's terms, the yield is actually higher--in this case, around 7-1/9 percent--since he's really investing only $9300. The huddled masses who queued up to purchase Treasury bills in person presumably were unaware that the bills could be bought quite effortlessly through the mails. All that's needed is a certified personal check (or a cashier's check) in whatever multiple of $10,000 the investor chooses, made out to the nearest Federal Reserve Bank, which he can locate by examining the folding money in his wallet. After the discount rate is established, the bank refunds whatever excess was paid when it sends the investor his certificate. (T bills in virtually any maturity can also be purchased through a banker or a broker, but this involves extra fees.)

The three- and six-month bills are sold every Monday at 1:30 P.M., E. S. T., simultaneously at all 12 Federal Reserve Banks. The nine- and twelve-month bills are sold only once a month; the date varies, but the same procedures apply. Most individual purchasers seem to prefer the three-month bills. These give maximum flexibility (after all, they turn into cash every 91 days) and permit the purchaser to keep rolling them over. Once he gets going, he can send a matured bill instead of a check, receiving in turn, a new bill, plus the bank's check for the discount difference. For investors who are unwilling or unable to meet the $10,000 minimum, at least one organization has begun pooling T-bill purchases as small as $1000, for fees no higher than $5 per $1000. Details are available from the American Board of Trade, 286 Fifth Avenue, New York, New York 10001.

One precaution: Short-term debt instruments, be they Treasury bills or any of the other notes that can be purchased through a banker or a broker, are not a long-term investment medium. This writer is always reluctant to foretell the future, but sure as sunrise, T bills and other short-term paper will not yield today's high interest rates forever. Sooner or later, they will drop back to five, four or even three percent; and at that point, they will be no more attractive (and considerably less convenient) than an ordinary passbook savings account. Short-term instruments such as Treasury bills are simply a temporary shelter wherein the investor can sit on ready cash and knock down a decent interest rate until the storm clears in stocks, bonds or whatever other investment medium he might be drawn to.

He might be drawn to Treasury bonds or notes--the ones that mature in more than a year. As already mentioned, they do exist and most are available in $1000 denominations. But since the Government hasn't sold many to the public in recent years, the usual way to purchase them is through a private dealer. The market for seasoned Government bonds--which is what these older issues are called--is similar to that for over-the-counter stocks. Individual dealers make the market and their profit usually comes from the spread between their buying price and their selling price. Since they don't like to truck with the public, the prospective buyer usually has to go through a stockbroker or a banker--and pay a fee. The going rate for a single bond purchase is $20, no matter what the price, but the investor ought to shop around, because the figure can vary wildly from one institution to another. On large transactions, the commissions diminish to one fourth of one percent.

As with most bonds, each Government bond or note is available in either bearer or registered form. Bearer bonds, like Treasury bills, don't have the owner's name on them. But, unlike Treasury bills, they pay semi-annual interest. Each bond will have one or more coupon sheets attached to it and, every six months, the owner clips off a coupon and deposits it at his bank, just like a check. Registered bonds, like savings bonds, have the owner's name on them. Here, there are no coupons to clip; interest arrives through the mail. Either way, it's paid twice a year. Since most bond transactions won't be made on the precise day on which interest is due, the new buyer must pay the seller his proper share of the accrued interest; this is automatically added to the sale price.

A preference for bearer or registered bonds is largely personal. Bearer bonds are marginally more negotiable; juice men, bookies and even pushers have been known to accept them. But they are also riskier and, because of the coupons attached, more of a nuisance. Banks and trust funds strongly prefer the convenience of registered bonds: There's no record keeping, the certificates are much easier to stack and they don't have to be shuffled through and clipped periodically. The big buyer of bonds might share this preference, but the small purchaser has more important things to worry about. However, he would be wise to insist that his certificates, whatever their form, be issued and delivered to him. Brokers offer to provide safekeeping for customers' securities, but their offices are so disorganized these days that the safety factor is debatable.

Government-bond prices are quoted daily in The Wall Street Journal and in the financial pages of most other major newspapers. (The best source of Government-bond information--in fact, the best source of facts on most aspects of the bond market--is The Weekly Bond Buyer, published every Monday at 67 Pearl Street, New York, New York 10004. At $96 a year, it can hardly be called a bargain, but for serious investors, it's probably worth the expense; for big-timers, there's even a daily edition.) Currently, about 50 different Government-bond series are available, with maturities ranging from 1970 to 1998. Prices are quoted per $100 face value, even though there's no such beast as a $100 Treasury bond. The reader has to multiply by ten to produce the real-life figure. Worse, quotes are in dollars and 32nds of a dollar. In other words, 67.16 means 67-1/2, which really means 67-1/2, which really means $675. This system supposedly saves newspaper ink.

Government bonds are identified by coupon rate and maturity date: 4-1/4s 74 describes the 4-1/4-percent bonds maturing in 1974, as distinguished from the 4-1/8-percent bonds or the 3-1/4-percent bonds that come due that same year. A hyphenated date, such as 3-1/4s 83-78, describes 3-1/4-percent bonds that mature in 1983 but are callable as early as 1978. This just means that if the Government cares to, it can redeem the bonds early (call them in)--an unlikely possibility nowadays, since this would have the Treasury borrowing money at over seven percent to retire a series of bonds paying less than half that. Government-bond quotations are usually accompanied by a percentage figure that describes the bond's yield to maturity, a computation reflecting the fact, already noted, that a bond selling for less than its $1000 face value will not only bear interest but will also give the owner a capital-gains profit if he holds it until it matures. A recent quotation for the Government's four-percent bonds of August 1972, for instance, showed them selling at 93.10--about $933 apiece--with a yield-to-maturity figure of 7.88 percent. This indicates that the $40-a-year interest until August 1972, plus the $67 profit when the bond pays off, would equal a net return of 7.88 percent a year on the $933 invested. Yield-to-maturity figures are a convenient means of comparing bond values, but they are mildly misleading because they combine interest profit and capital-gains profit without reflecting the different tax consequences of each. A deep-discount bond yielding the equivalent of eight percent to maturity is obviously a better buy, in tax terms, than a bond selling at a lesser discount but offering the same equivalent yield. In the case of the discount bond, much of the investor's ultimate profit will be taxable at the more favorable capital-gains rate.

Would-be suicides might take note of the fact that many Government bonds are acceptable at face value in payment of Federal estate taxes. Some of these "flower bonds" are currently available for $700 per $1000 bond, which means the wily decedent can pluck a posthumous profit of around 40 percent if he plays his hand properly. Not worth dying for, presumably, but something to think about when advising a dowager aunt.

Bonds issued by the U. S. Government--including ordinary bonds, notes, Treasury bills and even savings bonds--are properly regarded as the safest of all investments, since it's the Government that pays both interest and principal whenever they are due--and, you'll recall, the Government prints the money.

Most of the safety of Government bonds, plus slightly higher returns, is available in what are known as Government-agency bonds. These are issued by the dozen or so organizations--such as the Federal Home Loan Banks or the Federal National Mortgage Association--that are somehow related to the Federal Government. Much discussion centers around whether the Government would bail out bondholders if any of these quasi-official bodies were to default on their I. O. U.s. During the Depression, when so many farm mortgages were forced into foreclosure, the Treasury did step in to help the Federal Land Banks. Presumably, it would do so again. But because the Government doesn't have to, bonds issued by these organizations pay a slightly higher return (perhaps one-half percent more) than their cousins issued by the Treasury. As with Government bonds, the interest on agency securities is exempt from state and local income taxes.

In terms of tax exemption, nothing beats municipal bonds. These are issued by local governments. The name implies only cities, but states, villages, mosquito-abatement districts or any non-Federal governing unit can use them. They offer lower returns than Government bonds--the current rate is around seven percent--but they provide a unique appeal: The interest they pay is totally exempt from Federal income tax. If the bondholder lives in the state where the bond was issued, the interest is also exempt from state income tax. And, for some unfathomable reason, municipal bonds issued in Alaska and Hawaii before they became states are exempt from all income taxes--Federal, state and local--no matter who owns them. The speculative potential of municipal bonds is somewhat circumscribed, because there's no tax advantage to purchasing them on borrowed money. The Internal Revenue Service, with reasonable justification, feels that individuals shouldn't be allowed to deduct interest costs on loans financing the purchase of a tax-free income.

Obviously, the attractiveness of this sort of income increases with one's tax bracket. For the man who pays only 15 or 20 cents in taxes on each additional dollar he makes, tax-free income has little value; but when he begins giving up 50 or even 60 cents on the dollar, then the prospect of tax-free money becomes more alluring. Yet all that glitters isn't gold--perhaps for the best, since gold ownership is illegal for Americans. Municipal bonds are fraught with difficulties that aren't encountered in other bonds. First, while most municipal bonds offer similar interest rates, there's such a bewildering array of them, in varying denominations and maturities, that it's often difficult for buyers and sellers to get together. Municipal-bond prices are not quoted in any of the financial papers, because if such quotes were published, there would be no room for anything else. At last count, 92,000 government units had municipal bonds outstanding. Typically, each series of bonds might have from 10 to 30 maturity dates, so that if municipal-bond prices were quoted like those of stocks, there would be something in the order of 2,000,000 items to account for. The real reason municipal bonds aren't quoted is not their vast number but the fact that the bonds themselves seldom come to market. Investors tend to buy them as they are issued and hold them until maturity. Those that do come to market are handled like seasoned Government bonds, by private dealers who make their profit the same way grocers do: selling at a higher price than they've paid. As with the grocery store, the profit margin on slow-moving items has to be substantial. One of the current problems with municipal bonds is that prices have been plummeting so drastically that few dealers are willing to sit on big inventories; in this sort of environment, municipal bonds begin to resemble exotic pets: easy to buy but difficult to sell. However, when the general interest rate begins to fall, dealers will stand to profit from their inventory; they'll be more willing to expand and, therefore, more willing to buy.

The municipal bonds that dealers offer to buy or sell are listed and priced daily in a thick azure document called the blue list. Stockbrokers usually have access to a copy and it is through a stockbroker that the small investor usually purchases municipal bonds. The typical broker's fee is $5 to $20 per $1000 bond, regardless of the price the bond is selling for; as usual, the rates diminish on larger purchases. The broker contacts the appropriate dealer and buys at the dealer's asking price. The same procedure and fee apply for sales, except that these are made at the dealer's buying price, which (on small transactions such as this) might be five percent lower. While virtually all municipal bonds exist in $1000 increments, such certificates are difficult to buy or sell individually; $5000 denominations are more common and $10,000, or even $25,000, is the preferred unit. Most brokers who are concerned with more than just getting their commissions will rightly advise that purchases under $10,000 a shot are a mistake.

The perfect investor in municipal bonds would be someone like Mrs. Horace E. Dodge. This amiable lady, now deceased, sank her entire auto inheritance, some $59,000,000, into municipals, assuring her a tax-free income of several million dollars a year and liberating her from the annoyance of having to fill out a tax form every spring. The new tax laws have slightly diminished the attractiveness of such an investment for the select few who might be able to afford it (today, you have to fill out the forms), but the point is the same: It usually takes an enormous fortune to justify an investment in municipal bonds. A youthful investor, even if he has this kind of money, would probably want to do something more exciting with it.

He might investigate corporate bonds. These are issued by established (sometimes not so established) companies to finance new plants and equipment. Like butterflies, corporate bonds have been classified into all sorts of confusing subcategories; but from the investor's point of view, there are only two types: straight bonds and convertible bonds. With a few important distinctions, straight bonds are similar to Governments or municipals: They pay semiannual interest to maturity, whereupon the owner retrieves the principal. Convertible bonds have all the same features, with one important extra: They can be exchanged, at any time the bondholder wishes, for a fixed number of shares of the issuing company's common stock.

Straight corporate bonds offer most of the advantages of long-term Government bonds and generally attract the same sort of clientele. Because no corporation is deemed as creditworthy as the Federal Government, corporate bonds generally pay a slightly higher return--usually one-half to two percent higher--than comparable Government bonds. This makes them that much better an investment for income seekers who are willing to assume the concomitant risks, which are slight. Obviously, some corporations are riskier than others, and these have to pay more to borrow money. Two New York firms make a living grading corporate bonds (municipals, too) in accordance with the creditworthiness of the issuer. Like grades in a college for draft dodgers, the ratings range from triple A to C; all the ratings are highly conservative and much more useful to bond issuers than to investors. Most brokerage houses subscribe to one or both rating services, so the grades are available to anyone who cares to seek them out.

Corporate bonds are bought and sold just like common stocks, through a broker. The legal minimum commission is $2.50 per $1000 bond and the diligent investor might still be able to find a firm willing to do business at that low rate. (A comparable transaction in stocks might cost $20--$40.) But just as hospital fees rise during an epidemic, so have brokerage costs risen with public participation in the bond market. No brokerage house has to charge the minimum and, despite the lip service they like to pay to the cause of people's capitalism, brokers seem ever less willing to do business with small investors on the same terms they offer big ones. Typical fees on small transactions now range from five dollars to ten dollars per bond.

The biggest problem facing the individual who's interested in corporate bonds is not the fee he has to pay (even ten dollars per bond is only one percent) but the arm twisting and arguments he has to endure before he can convince his broker to accept an order. Most brokers loathe bonds. The bond experience of many is confined to the knowledge that the sales commission is tiny. Worse, bond investing tends to discourage the in-and-out trading that used to send stockbrokers to Europe every summer. When a customer buys a deep-discount corporate bond, selling at $640 and yielding the equivalent of nine percent until it matures 20 years later, chances are that he'll hold it until maturity. After all, his profit is guaranteed. Had he sunk the same money into stocks, he would surely trade more frequently, probably generating a minor jet stream of sales commissions in the process. As one brokerage-house official lamented candidly in The Wall Street Journal: "Bonds tend to tie up the customers' money."

Many bonds permit the issuing corporation to redeem them early, for a price slightly higher than the maturity value. As noted earlier, this call privilege is hardly a privilege, as long as the general interest rate remains higher than the rate prevailing when the bond was issued. In days when the interest rate was more stable, the call privilege gave the borrower an element of protection. If the interest rate were to decline significantly, he could call in his bonds and issue new ones at a lower rate. But at today's high rates, any drastic decline in interest costs would mean huge profits for investors who have purchased discounted bonds. The prospect of having their bonds called away at prices much higher than they paid shouldn't prove too disturbing. Bonds issued prior to the early 1960s are generally more likely to have less desirable call provisions than bonds issued since then, but these older bonds are generally the ones selling at the greatest discounts, because they were issued when interest rates were low. The net effect is that the investor who buys bonds for less than their face value shouldn't be overly concerned about call provisions. Only when the interest rate drops back substantially, to a point at which he might find himself buying bonds at or above their face value, should he be more careful, lest he find himself paying $1100 for a bond that the issuer can retire early for $1000. Newspaper bond quotations provide no information about the callability of corporate bonds, so the best source is a brokerage-house reference library or one of the two rating services previously mentioned.

Newspaper quotations of corporate bonds generally leave a lot to be desired. Fewer than 1000 of the great multitude of corporate bonds are traded on the big New York exchanges and only these are quoted daily in the press. Here's a typical quotation, from a recent issue of The Wall Street Journal:

67-3/8 54 Am T&T 2-7/8 s87 46 56-7/8 56 56 --2-1/2

The format and symbology are similar to those for stock quotations, and the imaginative reader ought to be able to deduce that this bond was issued by American Telephone and Telegraph, that it pays interest at a rate of 2-7/8 percent per $1000 bond and that it matures in 1987. As usual, the price figures have to be multiplied by ten before they make sense. The two figures before the name represent the high and low prices for the year--in this case, $673.75 and $540. The 46 after the maturity date is the number of bonds (in $1000 units) sold that day. The next three figures are the day's high price ($568.75), low price ($560) and closing price (also $560). The final fraction is the change from the previous closing price, showing, in this case, that the bonds lost $25 each, which is quite a lot for any bond to give up in one day. The interest-rate figure of 2-7/8 percent doesn't sound like much. It means that the bond returns $28.75 a year; and investors who are mathematically inclined can compute that, since the bond could be purchased for just $560, the return, in the purchaser's terms, would be around 5.12 percent. This, of course, doesn't include the $440 profit the investor is sure to make if he holds the bond the 17 years to maturity. The $440 spread evenly over 17 years means an extra $26 annually. Added to the $28.75 interest, this gives an annual return of $54.75, which means this bond is actually offering 9.9 percent a year, a respectable return by almost anyone's standards.

On the day the telephone bond just mentioned was selling to yield 9.9 percent, most other comparable bonds were offering less than 9 percent. An interesting aspect of the listed bond market is that the sharp-eyed reader of the financial pages, if he is blessed with a calculating machine or a penchant for long division, can often discover solid, high-rated bonds yielding perhaps a full percentage point above the prevailing rates. If his broker is quick enough, he might then buy an authentic bargain, of a sort that is rarely available in the stock market. Bernard Baruch owed much of his early fortune to a sharp eye for such price disparities. They exist because the listed market for bonds is gossamer thin. A day's turnover in a typical bond on the New York Stock Exchange might involve 10, 20 or perhaps 35 $1000 units. Institutions still dominate the bond market and, in institutional terms, 35 bonds is an insignificant number. You can bet your life insurance that Prudential (or any other big bond buyer) is not about to dump 5000 bonds into a market that can handle 35 a day. Institutional transactions are conducted through big, private bond dealers--the same ones who handle municipal and Government bonds. Surprisingly enough, many small-investor transactions are handled this way, too, because a good broker will know where the bargains are and often he can get a better price by avoiding the exchanges. This works well for the investor, but it makes the listed bond market somewhat mythical. Sure, the newspaper quotations represent real transactions, but real transactions made at a time when the same bond might have been selling elsewhere for $20 higher or lower than the listed price.

The one breed of corporate bonds that trades widely and well on the New York exchanges is the convertible bond. As noted, convertible bonds pay fixed interest to maturity, just like straight bonds; but they can also be exchanged, at the holder's option, for a predetermined number of shares of the issuing company's common stock. This means that "converts" (veterans accent the second syllable) can act like stocks as well as like bonds.

The use of convertible bonds as a corporate money-raising device increased twentyfold during the 1960s. At the beginning of the decade, converts were being issued at a rate of only a few hundred million dollars a year, and some of this was privately placed (sold direct to insurance companies or mutual funds), so that the public couldn't get at it. By 1969, convertibles were appearing to the tune of five billion dollars a year and the public was very definitely involved. Corporations like to issue convertible bonds, because investors like to buy them--so much so that they're usually willing to settle for a lower interest rate (perhaps one or even two percent lower, depending on the specifics of the deal) in return for the conversion privilege and the vision of limitless riches that usually accompanies it. So far, the corporations have got the better of the deal. From their point of view, convertible bonds are a cheap way of selling stock at high prices without hurting anyone's feelings. A corporation might sell $50,000,000 worth of convertible bonds and, as long as its stock keeps rising, investors will gradually exchange the converts for stock. When the maturity date finally rolls around, all the bonds will have been converted and, presto, the corporation won't have to repay the $50,000,000. More typically, when a company's common stock has risen to such an extent that its convertible bonds are selling far above maturity value, it will call the bonds, in effect forcing the bondholders to exchange them for common shares. In either case, the net result is simply that the company has sold more stock, thereby diluting the holdings of the prebond stockholders.

But this assumes that stock prices are rising. For anyone who hasn't noticed, they have been dropping lately, and so (with a handful of exceptions) have convertible bonds. In the past two years, the speculative public has taken a saturating bath in the convertible-bond market, mostly from buying converts on the assumption that they are just like stocks, only safer. The logic goes something like this: If the value of the related common stock were to rise, then the bond, being convertible into a fixed number of common shares, would rise, too. If the value of the underlying common were to fall, then the value of the convertible bond would stay the same--or at least not fall as much--because the convertible bond also pays fixed interest, which means it has value as a straight bond. Convertible bonds, as a popular observation had it, are like stocks, with a theoretical floor underneath them. But safety in the bond market is a relative term. When stock prices and bond prices began falling simultaneously, that theoretical floor looked like an open elevator shaft. Losses of 30 or even 40 percent in less than a year were all too typical.

An understanding of the intricacies of converts is best achieved through a real-life example. In the summer of 1967, RCA sold $160,000,000 worth of convertible bonds, yielding 4-1/2 percent interest and maturing in 1992. When the bonds were first sold, the prevailing interest rate was somewhat over 5 percent, but RCA got by with 4-1/2; investors were willing to accept a lower return in exchange for the conversion privilege. In this case, each $1000 bond can be exchanged, at the bondholder's option, for 17 shares of RCA common stock. RCA common was then selling for around $52 a share, so conversion wasn't profitable (17 times $52 is only $884). Yet the bonds began changing hands at $1050 each. The year 1992 was a long way off and, since stocks were rising, buyers valued the conversion factor considerably. For a while, their optimism seemed justified. RCA stock rose and so did the market value of the convertible bonds. For each dollar increase in the common, the bond, representing 17 shares, rose $17. Just a few months after it was issued, the bond was selling for $1235.

But that was as high as it got. Investors began to realize that inflation is as bad for companies (and thus for stocks) as it is for people. The stock market--RCA included--entered a long decline. Inflation also worked on the bond market. Interest rates rose, so bonds declined, too. As these words are written, RCA common is selling for $20 a share and RCA converts for around $650. Anyone who bought in at the peak price of $1235 is now out almost 50 percent of his investment and has good reason to question the carpentry of that theoretical floor.

The convertible-bond debacle may have been abetted by an obsolete cliché: that bonds and stocks tend to move in opposite directions. In the Twenties and Thirties, this was certainly true: When stocks were going up, bonds were falling, and vice versa. Even into the Forties, knowledgeable investors with a well-developed sense of timing used this simple rule of thumb as a painless and elegant means of making money. But, like many devices, it became obsolete during World War Two. Since then, stocks and bonds have sometimes moved in concert and sometimes at odds, but they have always declined together. Every major bond-market decline in the past 25 years has been accompanied by an equally major sell-off in stocks. Convertible bonds partake of the more volatile elements of both stocks and bonds, so investors shouldn't be surprised that converts can fall as quickly as they can rise. Economists and market analysts these days don't agree on very much, but there's surprising unanimity in the belief that the stock market won't rise significantly until inflation is brought under control and the interest rate begins to fall. Whenever that happens, bond prices will already be rising--and convertible-bond prices, representing the worst and the best of both worlds, might rise even faster. Obviously, the best time to buy converts is when all hope has been abandoned and both stocks and bonds are selling at their lows. This time, if it's not already at hand, it can't be too far off. As long as the convert is selling at its straight-bond value, the risk is no more than that entailed in an ordinary bond purchase and the prospective rewards seem considerably greater. Almost 1000 corporations--from AMK to Zapata Norness--have convertible bonds (or their close cousins, convertible preferred stock) outstanding; and, with stock prices as low as they are at presstime, a surprising number are selling close to their value as straight bonds. (Younger, less-seasoned companies--at least a few of which will surely take off when the stock market recovers--are more likely to issue convertible bonds than straight ones, because it's easier for them to raise money that way.) Details on all convertible bonds, including estimates of straight-bond value and computations of how much each would be worth if converted into common stock, are published monthly in Moody's Bond Surwey, which can usually be found within maroon loose-leaf binders on a stockbroker's bookshelf. From this information, the interested investor might want to evolve a check list of converts selling at or close to straight-bond value, and then determine which of these offer the most attractive common stock and which are closest to conversion value. (The nearer a convert is to its conversion value, the sooner will it rise in sympathy with its underlying stock.)

It should be obvious by now that bonds can fulfill different goals for different investors. Convertible bonds, when selling at their conversion value, are as risky and potentially as rewarding as any common stock--even more so if purchased on full margin. Converts selling near their straight-bond value are as sound as a regular bond investment, with the added possibility of distant profit if the underlying stock should revive. Straight bonds themselves, with their current high yields, offer guaranteed returns unparalleled in anyone's memory, plus the prospect of handsome capital gains whenever interest rates return to lower levels. When bonds are offering eight, nine or even ten percent--returns that compare favorably with the average performance of common stocks over the past 44 years--they are certainly no longer the sole province of widows, orphans or insurance companies. Bonds should be part of the portfolio of every investor, even the gutsiest.

Strangely, the bonds that appear to be the stodgiest are probably the most interesting for the nervy bond speculator who is willing to assume large risks for the prospect of proportionately large profits. The borrowed-money leveraging technique, already mentioned briefly, works only for straight bonds: corporates, Governments and the higher-paying Government-agency bonds. Here, the investor gets no tax preferences and no convertibility, just the chance to make (or lose) a real pile. During the current tight-money seizure, the necessary cash is difficult to come by, but this is actually a disguised blessing. The money will become available when the interest rate starts going down and, at this point, bond prices will be rising--just what the speculator wants.

Rather hypothetically, here's how the leveraging transaction would work. With the general interest rate heading downward, a speculator with $5000 concludes the cost of money will go lower yet, which means bond prices will rise. His first step is to set up a credit line with a bank willing to accept bonds against a collateral loan. Most banks will oblige, but the speculator would do well to shop around for the best rate. His first instinct--to approach a tried-and-true local banker--ought to be repressed. Like conventioneers, banks do things out of town that they'd never dare at home. To reduce lending rates at home would mean discriminating among favored customers. Better to charge a uniform high rate at home and then lend idle funds at a discount to trustworthy strangers. The peculiar result is that Manhattanites can often find better loan accommodations in Los Angeles, while at the same time. Angelenos are discovering they have a friend at the Chase. Interestingly enough, the best out-of-town banking connections nowadays are rural banks; they have more money to lend than their city cousins.

Assume that our speculator finds a bank willing to lend him $45,000, at nine percent a year, against $50,000 bonds posted as collateral. Here, the bank is financing 90 percent of the transaction; even 95 percent would not be unusual for Government bonds. His credit line secured, the speculator purchases $50,000 worth of eight-percent bonds. Commissions on a transaction this size would be minimal--$100 to $200, depending on the number of bonds involved. The speculator pays his broker $5000 (plus commissions) and the bank pays the remaining $45,000 when the brokerage house delivers the certificates. In effect, the speculator has bought all the action from $50,000 worth of bonds for a little over $5000. The interest cost on the collateral loan will amount to $4050 a year, but the bonds themselves pay eight percent--$4000 a year. So the net cost of carrying the loan is a lordly $50 per annum, tax deductible. This is very close to being what speculators happily call a free carry, difficult but not impossible to achieve these days. And note that even if the borrower had to pay ten percent on the bank loan, the cost to him would still be a manageable $500 a year, also deductible.

Having bought his bonds, the investor need only wait. If the interest rate remains constant, he can maintain his position indefinitely, at a cost of $50 annually. Of course, if the interest rate rises, he'll soon be in very serious trouble: His collateral will diminish in value and he'll have to post more cash or sell out at a loss. In fact, if the interest rate rises as much as one percentage point, he'll be wiped out. However, he has projected that the interest rate will decline; and if this occurs, he will profit handsomely. A two-percent decline in the general interest rate--from eight to six percent--will give his bonds a market value well over $60,000. He could sell out, pay his brokerage fees, repay the $45,000 bank loan and emerge with around $20,000. Not bad on an investment of just one fourth that.

Not too many people will be willing to assume the risks implicit in this sort of transaction, and for good reason: Money can be lost this way just as quickly as gained. But it should have a special appeal to risk takers who are familiar with the workings of the stock market, because it follows one of the fundamental rules of stock speculation: betting with the trend, rather than against it. In stocks, the successful speculator soon learns never to "call the turns." He won't buy into a declining market in the hope that it will reverse direction tomorrow, because he knows that stocks reverse themselves infrequently, so to bet on a turnaround is to bet against the odds. Leveraged transactions in bonds nowadays will almost certainly go with the trend, because there simply won't be much money to borrow until the interest rate--and the bond market--is headed in the right direction.

The more cautious investor, drawn to bonds because of their high yields, finds himself in a less justifiable position. Everyone desirous of a fixed income seems to have his own price. Some will be lured in at seven percent, some at eight, more yet at nine and ten. But all of them, once they become bond owners, find themselves in just the role they should avoid in the stock market. As new bondholders, they are unanimous in their expectation that the interest rate will turn down tomorrow. If they didn't expect the interest rate to reverse itself immediately, they would do better not to buy--to sit on their cash and await higher returns. So, to the extent that they are attracted to bonds solely by their high yields, individual bond buyers are trying to call the turns.

But, to repeat: Stocks and bonds are different. The most fascinating aspect of the bond market, from the small investor's point of view, is that there he can call the turns, with astonishing regularity. Those who know the stock market have heard the old saw that the small investor is always wrong. Professional stock players scrutinize what are known as the odd-lot statistics, measuring the activity of investors (invariably amateurs) who buy and sell fewer than 100 shares at a time. When the odd-lot figures show small investors buying heavily, the pros take it as a time to sell; and when the odd-lotters start selling heavily, the pros begin to buy. Over the years, this simple technique has produced many more profits than losses. The rationale for its success is that when small investors go on a stock-buying bender, the market is intoxicated with speculative excess and likely to stumble; and when small investors are so disenchanted that all they want is to sell out and go elsewhere, then the bottom is close at hand.

The bond market turns this upside down. In the words of Sidney Homer, partner of the nation's biggest bond house and éminence grise of the Wall Street bond fraternity, "The public is extremely well heeled and extremely interest-conscious." Small-investor money is drawn to bonds only when interest rates are rising. The public still brings its remarkable ability to buy at the top and sell at the bottom; but in the bond market, the result is not disaster but distinction. High interest rates mean low bond prices and the small investor's instinct for the top gets him into bonds at the very bottom. In fact, when interest rates are in the doldrums, the market belongs entirely to professionals--big institutional investors who, like stamp collectors, spend much time exchanging esoteric scraps of paper among themselves. But when interest rates approach peak levels, amateurs get interested. This was true three times during the Fifties, it was true in the "credit crunch" of 1966 and it seems true today. As one bond analyst hypothesized to a Wall Street Journal reporter: "The figures suggest that the little guy is the final reservoir of money reserves and that when he comes into the bond market, it's because prices are about to bottom out." If prices do bottom out, of course, the little guy will profit handsomely.